America's mutual funds

The scandal spreads

A wave of suspensions and sackings hits a $7 trillion industry

“THE full extent of this complicated fraud is not yet known,” said Eliot Spitzer, New York state's attorney-general, when he launched an investigation into mutual-fund fraud on September 3rd. A month on, it still isn't. The industry, which oversees $7 trillion of Americans' assets, is fighting for its reputation. Several dozen class-action lawsuits have already been filed. Mutual funds and their investors are wondering what Mr Spitzer's probe, and another by the federal Securities and Exchange Commission (SEC), will unearth.

So far one of the four firms cited in Mr Spitzer's original complaint, Bank of America, has fired three employees. Another, Strong Capital, said late last month that it would make “appropriate reimbursements” to clients if an internal review finds they have been harmed. Merrill Lynch, Prudential and Alliance Capital have also fired or suspended staff. Following a second complaint by Mr Spitzer, on October 2nd a former trader at Millennium Partners, a hedge fund, pleaded guilty to securities fraud. The chief executive of Security Trust, another company the attorney-general is after, resigned on October 6th. Others have received subpoenas from Mr Spitzer.

Like investment banks, with which Mr Spitzer reached a settlement in April, mutual funds have long been known to have potential conflicts of interest. On the one hand, fund managers' earnings are related to how much money they manage. On the other, their quest for size can sometimes clash with the financial interests of their investors. Although they have a fiduciary duty to investors, they stand accused of breaching it.

Market timing and late trading, the two practices currently under scrutiny, are litmus tests of fund managers' loyalties. Market timing exploits inefficiencies in the way the prices of shares in mutual funds are derived from the prices of underlying securities (such as shares in listed companies). The value of a mutual fund does not change in the course of a day: its shares are bought or sold at a price fixed by the fund's manager, who also acts as the primary market maker for the fund's own shares. Fund prices are usually fixed at the end of the previous trading day. Thus an American manager whose fund specialises in Japanese shares uses stale closing prices from Tokyo, established 14 hours before trading ends in New York, to fix the value of his own fund. If market moves in America suggest a sunny outlook for the next day in Japan, a market timer, usually a professional trader, can buy the mutual fund at the fixed price, reflecting stale Tokyo prices, and then sell the fund's shares back to its manager the next day at a profit.

This is not illegal. But it hurts long-term mutual-fund investors, because the market timer's quick sale reduces the fund's asset value and imposes transaction costs on the fund. Yet fund-management firms are tempted to allow market timing by traders who promise to throw more business their way in the future. The practice becomes legally murky when mutual funds say in their prospectus, as most do, that they act to prevent timing, but still allow the practice. Some firms explicitly say that they accept or even invite market timing.

Late trading is tempting for mutual funds for the same reason: if fund managers allow it, late traders will put more business their way. Helped by friendly fund managers, late traders place buy or sell orders after the value of a fund has been set at the end of the trading day. They can then profit from news about companies whose shares are held in the fund. This is prohibited by federal securities law, but can go unnoticed if traders and fund managers cover their tracks.

The scandal is prompting investors to question whether mutual funds are acting in their interest. No individual is likely to have lost much, yet the collective sum is large. William Goetzmann of Yale University estimates that in the 17 months to June 1998 trading on stale prices in 116 mutual funds cost investors 0.44% of the funds' assets, or $1.5 billion. This shaving of returns might not be spotted during a bull market. In a bear market, where gains are harder to come by, investors are more sensitive.

Regulators are now seeking ways of straightening out mutual funds' allegiances. In testimony to the Senate banking committee last week William Donaldson, chairman of the SEC, said that the agency will demand more transparency on funds' expenses and commissions, and more information on their policies on market timing. The SEC will probably recommend that mutual funds adopt “fair-value” pricing: instead of actual, stale prices, mutual funds would price Japanese stocks, say, according to what they think their value should be after New York's trading day. If funds did not use fair-value pricing, they would have to explain why.

However, fair-value pricing may also be open to abuse, because of its subjectivity. Indeed, until recently the SEC itself was disinclined to advocate fair-value pricing, on the ground that it involved “complicated judgment calls”. Even with fair-value pricing, investors would have to rely on simple faith that mutual funds were not breaching their fiduciary duty. The coming months will show whether fund managers deserve Americans' confidence.